Incentive Pay and Systemic Risk

Incentive Pay and Systemic Risk

Rui Albuquerque, Luis Cabral, Jose Correa Guedes

Series number :

Serial Number: 
490/2016

Date posted :

November 01 2016

Last revised :

August 30 2018
SSRN Share

Keywords

  • systemic risk • 
  • bank regulation • 
  • relative performance evaluation • 
  • optimal contracts

We show that, in the presence of correlated investment opportunities across firms, risk sharing between firm shareholders and firm managers leads to compensation contracts that include relative performance evaluation. These contracts bias investment choices towards correlated investment opportunities, thus creating systemic risk. Furthermore, we show that leverage amplifies all such effects.

In the context of the banking industry, we analyze recent policy recommendations regarding firm managerial pay and show how shareholders optimally undo the policies' intended effects.

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Authors

Real name:
Luis Cabral
Real name:
Jose Correa Guedes